Day of the (brain) dead

By Buttonwood

WHEN a book with the title Zombie Economics: How Dead Ideas Still Walk Among Us arrived on my desk, I figured it could go one of two ways. One possibility could be that the zombies were Keynesians, discredited in the 1970s but back in favour today. But the cover illustration of trickle-down economics and efficient financial markets illustrates that the Chicago school is deemed to be the haven of the undead.

It is an entertaining and thought-provoking book by an Australian academic John Quiggin, which also works as a good summary for non-specialists of how the economics debate has developed (NB the book will not be published until October). The analysis is quite worrying. For those who can recall the 1970s, the Keynesian consensus was coming under attack by the monetarists led by Milton Friedman. The latter group argued that 30 years of post-war Keynesianism had led to the combination of high inflation and unemployment. The attempts to fine tune the economy through fiscal policy were self-defeating. Instead governments should control inflation through monetary policy and use supply side reforms (privatisation, attacks on the power of the unions) to reduce unemployment and boost growth. These ideas were enthusiastically taken up by Ronald Reagan and Margaret Thatcher. They then appeared to be vindicated by the "great moderation" - the long period of steady growth and low inflation from the mid-1980s onwards.

As Mr Quiggin points out, this school generally saw government as a problem and argued that economies, left to themselves, will generally tend towards equilbrium. Elaborate models were created that showed how smoothly economies would work, given rational consumers and producers. This led them to struggle to explain why recessions did occur. Economists came up with "real business cycle theory" and "dynamic stochastic general equilibrium" to explain why such fluctuations happened. This ended up blaming the Great Depression, for example, on the New Deal policies of Franklin Roosevelt, even though he didn't take office until 1933 when a lot of the damage had already been done.

The problem, as Mr Quiggin argues, is that economists develop their elegant models, with rational consumers, perfect information and liquid markets and then try to adapt it to reality. In other sciences, one would surely take the world as we find it, full of irrational consumers, imperfect information and markets that suddenly freeze. The result was that much of the new economics failed to predict the credit crunch of 2007 and 2008. Nor did the Chicago school have much to say in response, save to oppose the various governments in their stimulus plans. This led to the unfortunate situation in which

The result was that the policy options dwindled to two: do nothing and wait for the economy to recover on its own, or undertake public expenditure on a massive scale to cushion the impact of the downturn.

It is hard to disagree with the author's view that:

sustained periods of high unemployment cannot be treated as marginal and temporary deviations from general equilibrium. We must model a world where people display multiple and substantial violations of the rationality assumptions of microeconomic theory

In my view, economists have failed to take enough account of the impact of financial markets, perhaps because, until the 1980s, these markets seemed relatively unimportant. In the era of floating exchange rates and free capital movements, they have become a lot more important and this is where the insights of Hyman Minsky become crucial; in particular, that financial markets are inherently unstable. (This is the planned subject of my column this week.) Worse still, central banks have encouraged speculation by rescuing markets at times of crisis without discouraging markets during bubbles.

So it's not just that economists don't have all the answers, for many years they weren't asking the right questions.